Tuesday, April 7, 2009

My thoughts on Regulation, Part 1

It seems every other article is talking about regulation and I want to let my thoughts play out a little on the topic. This is part one of many to come:

Listen to Nicolas Nassim Taleb's podcast from last week at EconTalk. Or read his "The Black Swan". Either way, you'll get the sense that Taleb understands the origins of uncertainty. He gives an analogy about traders using Value at Risk (VAR) before Black Monday. In their models, the traders priced in a maximum of a 10% daily loss. Never before (at least not in recent memory) had the market sold off so precipitously that the models needed to factor in the possibility of a 15% drop in the market. It was unfathomable to factor in that kind of loss. The Dow dropped 22% on that Monday. Taleb then goes on to talk about how traders adjusted. He claims they made the mistake to assume that 22% was now the 'new' preposterous loss scenario. Models were readjusted to represent 22% as the worst-case scenario.

Taleb's point is that future disruptions will look nothing like those of the past. The whole theory behind crashes and runs on the banks and 100 year floods is that you are blind-sided by them because they are outside your vantage point. You don't know from where the next 'crisis' comes. In fact, my favorite quote from that podcast is when Taleb is talking about probability. I paraphrase: "If someone is telling you that the chances of an event are 1 in 10,000 years, and that person is NOT 10,000 years old; they are relying on information outside of their direct experiences." I.E. Take it with a grain of salt.

All this leads me to an article I just read by Oliver Hart (Harvard) and Luigi Zingales (UChicago). Overall I'm quite a fan of Zingales, but I think Taleb would cringe at this prescription. I know I do.
In our mechanism, when the CDS price rises above a critical value (indicating that the institution has reached an unacceptable threshold of weakness), the regulator would force the LFI to issue equity until the CDS price and risk of failure back down. If the LFI fails to do this within a predetermined period of time, the regulator will take over.

This regulatory takeover would not be dissimilar to a milder form of bankruptcy, and it achieves all the other goals of bankruptcy -- discipline on management and shareholders -- without imposing any of the systemic costs.

Credit-default swaps have been demonized as one of the main causes of the current crisis. It would be only fitting if they were part of the solution.
While the article is purposefully vague, it still consists of prescriptions that address the problem we are facing now, not the problems we will be facing in the future. And herein lies the problem with regulation: If not breeding the next crisis, regulation at best can address what plagued us, not what will plague us.

I'm not advocating regulators needing to predict the future, but in these series of posts I will argue that the best remedy to fraud, systematic risk, etc. is regulation that is vague, spirit-of-the-law oriented, and most importantly, objective instead of subjective. I'll be talking about the SEC and other regulatory bodies, lots about Timmy G's developing proposals, and the history of regulation. I'm looking forward to expanding on the topic.

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